Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Feeling Rich, Going Broke

"You can never be too rich or too thin," goes the old boast, popular among jet-setters and debutantes. Nowadays, though, many of us appear set on discrediting both claims. First, Ally McBeal proved that -- indeed -- it is possible to be too thin. Then, many of us got to feeling so rich from the 1990s stock boom that we lost all sense of prudent budgeting and debt management.

Like Robert Downey Jr., let's leave Ally McBeal for the moment, to focus on our personal finances. In particular, let's look at a phenomenon that economists are calling the "Wealth Effect."

According to the theory, we spend more when we feel that our finances are flush -- when our net worth (everything we own minus everything we owe) increases, even if our salary stays flat. So, when stock prices go on a remarkable, decade-long, upward binge (sound familiar?), a lot of ordinary people find themselves suddenly richer, and boost their spending accordingly. In other words, they spend more than they earn on the job, at least temporarily.

Is this what happened in the 1990s? If so, is this "Wealth Effect" a contributor -- at least in part -- to the parallel spike in personal bankruptcy filings?

On the macro-economic level, we certainly won't settle this raging academic debate here. Nonetheless, a quick stroll through the relevant data is an eye-opener well worth sharing. On an individual level, Fools will find some compelling personal finance lessons along the way.

Income gains hold steadyOver the last 50 years, we've been blessed with a steadily rising real per capita income in the United States (the "real" means the numbers are adjusted for inflation), as you can see in the chart below. This means that our salaries, on average, have risen faster than inflation (if they had not, this "real income" line would be flat, rather than trending upward).

What about the 1990s? Well, our salary gains continued to beat inflation -- a good thing, and not to be taken for granted -- but, otherwise, the '90s don't look much different from the 40 years that preceded them.

Net worth goes through the roof!Income gains are cool, but now for the really good news: We're rich!

Over the past decade, household net worth broke free from its historical bounds and attained new heights. By the end of 1999, the average family was worth more than 500% (5 times) of its annual income. Even accounting for the massive stock slide through the end of last year (clearly visible in the chart below), household net worth still closed the year 2000 at 491% of annual income, well above its half-century norm.

(Note: if the phrase "net worth is equal to 491% of annual income" leaves you bewildered and searching for the exit, we've posted a quick example to help get you back on board).

Where did all this wealth come from? Guess.

You got it -- from the stock market (in the chart above, look at the Stocks, Mutual Fund Shares, and Pensions line through the 1990s). Even better news: this binge in stock market wealth was shared more broadly than ever before. A separate Fed study -- its every-three-year Survey of Consumer Finances -- estimates that the proportion of American families with stock holdings (either directly or through mutual funds) increased from 32% in 1989 to 49% in 1998 (although, to complete the picture, we should add that the wealthiest 5% of households still own three-quarters of this stock by value).

So we're all better off, right?Maybe. But, given the uplifting trends in income and wealth, it's not so obvious as you might expect. In fact, there are more ominous signals than happy ones in the aggregate picture.

For starters, consider mortgage debt. In the 1990s, the balance owed on our homes -- as a percentage of annual income -- extended its staggering half-century ascent, a climb that has seen it rise from 20% of annual income in 1952, to nearly 60% by the end of 2000. Our insatiable appetite for space has driven the median new home size from 1,385 square feet, in 1970, to 2,030 square feet in 1999, but our income gains have not kept pace. As a result, we live in bigger homes but carry much bigger mortgages. (For more information on how much home you can afford, visit our Home Center.)

Similarly, total consumer credit -- essentially all non-mortgage consumer debt, including credit cards and automobile loans -- maintained its steady rise through the '90s. Total credit outstanding has risen from 11% of annual income, in 1952, to nearly 19% by the end of 2000.

And providing the stretch-wrapping on our tightly bound personal finances, our average cash savings, as a percentage of annual income, dropped from a high of more than 70% in the late '80s, down to just 54% by the end of 2000. This might not look so bad, on the surface, since cash savings at 54% of annual income meets the financial planners rule of thumb (three to six months of income in ready cash is 25% to 50% of annual income). But these aggregate figures include the disproportionately large cash balances carried by current retirees. The average cash cushion for a young family is substantially smaller, with far too many living month-to-month.

What do you get when you add this record debt and reduced cash savings to the '90s wealth boom? Answer: Personal bankruptcy filings roughly doubled between 1990 and 1998. A brief downward trend after 1998 gave some cause for optimism, but was quickly erased early this year, as the economic slowdown powered a 17% sequential rise in first quarter 2001 personal filings, back to a level matching 1998 highs.

Riches to rags?Think all this bankruptcy is purely a poor folks' problem? Think again.

According to a recently published study by economists Dean Maki and Michael Palumbo, the much-discussed decline in the national savings rate has been driven almost entirely by the wealthy -- more specifically by "wealth effect" spending among the richest 20% of Americans. The poorest 40% has actually increased its rate of savings through the '90s.

"So what," you say? "Why shouldn't the rich cash in some wealth during a bull market?"

Well, in principle, it's not a problem, but according to the Fed Survey of Consumer Finances, not all of these wealthy families have their budgets under control. Among the richest 10% of American families (some pretty wealthy folks), 11.5% had 1998 debt burdens above 40% of income (monthly debt payments ate up more than 40% of the monthly paycheck), up from 7.8% of such families in 1989, numbers that don't differ much from those posted by the poorest 25% of U.S. households.

And believe it or not, among 1998's richest 10%, the median family carried $2,000 in credit card debt. Could it be a case of "wealth, wealth everywhere, but nowhere the cash to make ends meet"? Regardless, these numbers highlight the razor-thin edge between building wealth and building debt -- a perilous line that even the nation's most prosperous have to walk.

What should Fools learn from all this data?Don't let the skyrocketing value of your retirement accounts or other long-term stock portfolios give you a false sense of financial control. In particular, don't let the market drive your short-term spending habits, especially if you will balance the budget by turning to debt -- either through credit cards or refinanced mortgages -- rather than stock sales.

Sure, tax-advantaged mortgage payments are a good deal, but you've got to make them, in good times and bad. Leave yourself ample breathing room. Your banker may think 40% of your income in debt payments is "acceptable" but remember, her objectives are slightly different from yours. And if you think your stock portfolio gains will consistently beat 18% credit card payments, you may already be headed for bankruptcy court.

Many of us are ignoring the importance of sufficient liquid assets -- in other words, having plenty of cash on hand. We're stretched way too tight. The next time a big, unexpected bill hits, the last thing we want is to be forced into selling stocks, refinancing our mortgage at a lousy rate, or taking on credit card debt. We'd much rather tap some short-term savings, if we've had the foresight to accumulate them.

ConclusionWhen it comes to our personal finances, we can learn a lot from the world of business. One such lesson is the fundamental distinction between the balance sheet -- a snapshot of total wealth -- and the cash flow statement -- money routinely entering and exiting your family's "operations."

Warren Buffett, perhaps the best businessman of them all, didn't build his wealth by never selling his stock investments, contrary to popular myth. The truth is that Buffett sells stock all the time. BUT, because he manages his cash flow carefully, he has the luxury of valuing the stock assets on his balance sheet by their stable, intrinsic value. He never puts himself at the mercy of the wacky stock market. In other words, he's never forced to sell at a bad price, and when prices are particularly good, he's got cash on hand for buying. This principle extends beyond stocks: For example, being forced to sell a big house in a down market is no fun either.

So, unless you are retired or otherwise living off of accumulated wealth, be sure to manage your finances according to your cash flow statement and not your balance sheet. Don't let the "Wealth Effect" cripple your retirement or, worse, push your finances down the insidious road to bankruptcy.